Friday, December 7, 2012

Has MBS become a crowded trade?

Primary dealers net holdings of MBS (mostly agency) hit another record. Employing a hole in the Volcker Rule (see discussion) dealers are making a bet that the Fed will be there to take this paper off their hands. What if the dealers are wrong?

Source: NY Fed

As discussed earlier (see this post), the Fed isn't jumping to buy large amounts of MBS at this juncture. The central bank's balance sheet as well as bank reserves and the monetary base have plateaued. Furthermore the headline employment numbers (with the exception of construction) show a marked improvement (see this post from Lee Adler). Both surveys of US employment are on the right path.

Source: ISI Group (also the US Labor Department)

What happens if the Fed goes into a long-term holding pattern due to these improved indicators and the dealers start selling their inventory? Mortgage rates would rise and refinancing would slow. Seems that "smart money" is not betting on the big refi wave continuing - which means they are not convinced mortgage rates (and MBS yields) will keep moving lower.

JPMorgan: - Many potential entrants to
the mortgage industry fear that a sell-off would
crush volumes, leaving originators to fight over a
dramatically smaller loan market, and struggling to
deal with large fixed costs. Indeed, roughly 70% of
all originations are refinances currently; a big
enough sell-off would make originators compete for
the remaining 30% of purchase borrowers. Thus,
despite the Fed’s assurances of “low for long”, we
have not seen a large influx of private equity, hedge
fund, or other capital into mortgage origination,
partly out of fear that a sell-off would take volumes
down significantly, saddling them with a large
infrastructure and fixed costs.

Have the long-term mortgage rates (15 and 30y) bottomed here? The on-the-run 30y FNMA bond is off the highs but it has had quite a rally this year (yields have declined). Is it possible that MBS may have become a crowded trade? If the Fed continues to stay put in the next few weeks, we may indeed see a correction. And given high dealer inventories, it could be quite sharp.